Synthetic Equity: How to Compensate the Non-Family Executive Who Wants an Equity Share of the Enterprise

By Robert M. Fields

The last few decades have seen a significant growth in the number of relatively large (revenues of at least $25 million) family-owned, non-public companies. As these companies increase in size, or the founders head for retirement, they often have to bring in non-family executives to hold high-level positions. Increasingly, these executives, being intimately involved in the financial success of the companies by which they are employed, desire to participate in the increase in the value they helped create. Thus, they often turn to the family-member owners and request equity interests in the companies.

Most often, this puts the family owners in quite a quandary. For a number
of reasons, they are usually loath to granting equity interests to
non-family members. These reasons include:

For purely emotional reasons a desire to keep ownership of the company
exclusive to themselves and to their progeny.

A desire not to spread ownership beyond family members because the
interests of the non-family executives often clash with those of the family.

A desire not to have to deal with the legal rights of minority
stockholders.

A desire not to make confidential financial information, such as the
amounts earned by the family members, available to the non-family members
(as may be required in the case of LLCs and similar business entities).

Lastly, a desire not to be put into the position of having to redeem
company stock at the time of the termination of employment of the non-family
executive or, in the alternative, have to deal with non-family owners who no
longer work for the company.

Nevertheless, the owners of the company are often quite aware of the value
the non-family executives bring to the table and, accordingly, want to
satisfy their requests. Caught between two competing interests, they are
often at a loss as to what to do.

This is where constructing “synthetic equity” interests go a long way to
assuaging the demands of the non-family executives while keeping real
ownership of the company solely within the family groups. This “synthetic
equity” is essentially what it sounds like. It is a mix of short and
long-term cash incentive plans that have the look and feel of basic equity
interests.
First, there is the short-term (annual) incentive component that is
intended to replace dividends and other similar distributions. However, in
stark contrast to actual dividends, these incentive payments are made only
upon the attainment of specified financial targets and goals. At the
beginning of each year, the company and the non-family executive will agree
to a set of goals and targets to be met during the year. For example, they
may identify three goals, such as gross revenue, net profits and market
penetration and assign targets such as $X gross revenue, $Y net profits and
Z% additional market penetration for the year. If, at the end of the year,
these goals and targets are just met, the executive will receive his target
bonus, usually defined as a percentage of salary. If the targets are
exceeded, the bonus will increase, up to a maximum percentage. If the
targets are not met the bonus will be reduced until a specific floor is
reached (such as 80% of target), below which no bonus will be paid. For many
of my clients, I have included a “negative bonus” structure if actual
performance is significantly below target. Not only will no current bonus be
paid at year end, as a result of a negative bonus, the following year’s
bonus, if any, will be reduced by a specified amount.

The beauty of this type of incentive program is in its flexibility. Each
year different goals, targets and bonus levels can be chosen which meet the
current business interests of the family owners and which take into account
current financial realities. The non-family executive can be handsomely
compensated under such a program; however, if the goals and targets are
carefully structured, the family owners will always come out ahead of the
game even after the year-end bonus is paid to the executive.

The other component of “synthetic equity” is a long-term phantom stock plan
pursuant to which a payment of a specific amount is made to the non-family
executive upon (i) a “liquidation event” (i.e., a stock or asset sale of the
company), (ii) if the owners desire, upon the death of the executive (where
the amount of the payment can be recovered from a key man life insurance
policy held by the company on the life of the executive) or (iii) in certain
cases, upon the termination of employment of the non-family executive on or
after a certain date or event (such as retirement). In rare circumstances,
family owners have elected to allow payments to be made upon a termination
of employment at any time.

The amount of the payment is usually a small percentage of the amount
realized upon a liquidation event, but only if the sales price is equal to
or greater than a predetermined base amount. If the sales price is greater
than the base amount, the percentage of such amount paid to the executive
can be increased; provided, however, that any increase will be regulated so
that the owners will always come out ahead even after the payment to the
executive. For example, the increase in the sales price of the company often
twice the increase in the amount of the payment to the executive. If the
sales price is below the target amount, no payment (or an extremely reduced
percentage) will be paid to the non-family executive.

If the owners desire, payments under the phantom stock plan can re
restricted only to those executives who are employed upon the liquidation
event or who remained employed to a specific date or event, such as
retirement on or after age 65. A “redemption” of phantom shares made upon
termination of employment at retirement or upon death will be based upon
either a fair valuation of the company or a formula (often a multiple of
EBITDA or book value). In the event of a payment triggered upon an event
other than the liquidation of the owners’ interests in the company, I
usually draft the phantom stock program to provide that the payment will be
stretched out over a number of years, with each annual payment is limited to
the lesser of (i) available cash profits or (ii) a specific dollar amount;
thus, guaranteeing that the payment will not put the company into a
cash-strapped position.

Payments on the phantom stock can be conditioned upon the executive
completing a minimum number of years of employment with the company and are
often withheld upon a termination of employment for cause or, as mentioned
above, a termination of employment before a certain date (such as normal
retirement date under the company’s pension plan), or before a liquidation
event. These restrictions place “golden handcuffs” on the executive as they
give him or her an incentive to remain employed for the long haul.

In summary, synthetic equity can be designed to pay the executive for
superior financial performance. The executive can be highly compensated, but
only upon events that result in a superior return to the family owners. This
gives the family owners the best of all worlds, retention of actual
ownership within the family ranks and payment to the executive only upon a
net-positive return to the company. At the same time it goes a long way to
satisfying the non-family executive’s desire to participate in the profits
and growth in value of the company. As a result, all parties are happy and a
significant thorn of contention is removed from the employer-executive
relationship. These programs are quite flexible and can be individually
designed to meet the specifics of any situation.

Robert M. Fields provides executive compensation expertise to both
executives and corporate management on employment and severance agreements,
and advises in the installation of executive incentive programs. Contact:
rmf@fieldsconsult.com.

The contents of this site, and our newsletter Related Matters provides general information only. It is not intended as legal or accounting advice. Accordingly, readers should not act upon information in this publication without seeking professional advice. Copyrights to the articles in this newsletter (and online) remain with the authors and the UMass Amherst Family Business Center and may not be reprinted without permission.